Common Sense Stock Market Basics

Note: This post is a very simplistic intro to how a stock market works. If you intend to become a well informed investor than additional knowledge is necessary!

The stock market is a (virtual) place where huge amounts of money are traded for ownership of the companies whose stock is listed on the market. It should be obvious that those who control more money have more influence on the market, but that's not the only influence on the market. The price of each stock varies - sometimes rapidly - based on news impacting the company, it's competitors, or the economy in general. The people who make the most money on the market are those who get access to, and react to, the news fastest!

Historical Backdrop

The stated rationale for stock markets is that they allow an efficient means for companies to raise capital to fund their growth. They perform this function very well! But, in a world where the US Federal Reserve Bank is not Federal (it's privately owned), not a Reserve (it keeps no significant amount of money), and not a Bank, then the well informed investor looks for other functions beyond the stated one. What else does the stock market do?

To meet the stated purpose, a stock market would only need to provide a way for a company to sell it's shares to the public. Once these initial share offerings are purchased from the company, the company is no longer directly affected by the market. So the markets have a secondary purpose of allowing current stock owners to sell their shares, or to buy more, whenever they want. That leaves one big question - what is a share of the ownership of a company really worth?

How Share Price is Determined

Every company has assets (things of value that they own) and liabilities (things they owe to others). Subtract the liabilities from the assets and divide by the number of shares outstanding, and that should be the value of a stock, right?

This number is important, so it has a name. It's the Book Value of the share. But that's rarely the price at which the share sells. There are investors who only look to buy shares at or below book value. These investors are referred to as Value Investors. Other investors look for growth in the company's profitability over time. Profitable companies grow the book value of their shares every year.

Here's a hypothetical situation. Suppose I offered you $200 a year from now in exchange for $100 now. Would you take it? If you knew where I live, and believed me to be a good person , you would likely take the offer. But those who know nothing about me, might refuse, thinking that you would never get your money back!

Changing the offer to $200 in a year for $250 now would result in everyone refusing the offer. Between the $100 and $250 there is a dollar value at which you would have difficulty deciding. The implied rate of return at that point is called your discount rate. It is the return you would need annually to feel that you would take on the risk of the investment.

And that's where we start to get into trouble!

Perceptions and the Market

The market behaves erratically because all of us differ in our perceptions of the future value of the company, of our discount rate, and of the direction of the market and the greater economy. An investment that makes sense to one person is unacceptable to another. The current stock price is a balance between these perceptions.

What is our basis for the perceptions we have? For those who are successful, it's based on a thoughtful approach of gathering significant data, including knowledge about the company, it's products, management, competitors, suppliers and customers. But for most of us, it's based on our emotional response to a limited subset of this data. Sadly, our emotions can easily be manipulated!

And so we come to the third reason why the markets were established.

The Herd Mentality

Humans are social animals. We want to do what others are doing. We tend to move in groups. Investors are the same way. All it takes is for someone to manipulate our emotions to get us to change directions! The wealthy families who own more than 50% of the market have the resources to manipulate our emotions.

The average daily trade across all US stock markets last year was $516B. The total value of stocks in the market exceeds $100T. Daily trading represents around 0.5% of the total shares outstanding. Those who can exert control over the market do not need to sell more than a small percentage of their holdings over a few days to start a market downturn. Others see the downtrend and they start selling their portfolios, increasing the downward pressure. Fear of loss is a strong motivator. Less educated investors begin to sat things like "Is the market going to zero?"

As the market nears the bottom of a down cycle - a "bear" market - the volumes of stock being sold increase dramatically as the less sophisticated investor capitulates and takes whatever they can out of the market. Around that time, the wealthy buy back the shares they sold to cause the downturn in the market. The market rises quickly. Historically, most of the largest percentage increases in the market occur in the first few weeks after the end of the bear market.

The key lesson here is that sophisticated investors sell high and buy low. Emotional investors do the opposite. So the third major function of the market is to provide an efficient mechanism for taking money from the less wealthy, and transferring it to the more wealthy!

Can You Actually Make Money in the Market?

The first questions to ask yourself are:

Do I have the time needed to become a successful investor on my own, or do I need advice? and

Can I control my emotional responses to what the market is doing today to look at the longer term?

Understanding market psychology and having access to real time information allows the well informed investor to sell before the stock price falls, or buy before the price gains. This is a tremendous, and expensive, advantage! Trading in the market without having the necessary information is even more expensive as it puts your entire portfolio at risk!

The final question to ask is then "How much am I prepared to spend to be fully informed and up to date in real time?" As you estimate this number, be sure to include your time at an hourly rate that would make you happy to spend more time at work. Our suggestion is that you use at least $50 an hour for your time.

The good news is that, if you follow a winning system and put n the work, you can make money!

What are Possible Winning Systems?

To compete with the larger, well-informed investors, the small investor (anyone with less than $1M in the market) has a few potential strategies to consider. They are:

1. Try to compete in real time, using a trading trend prediction model. This is called Day Trading and is really a full-time hobby! 90% of day traders do not make any money after working 50 hours a week. Of the 10% who do make some money, only 10 to 15% of those will cover their time at the previously suggested rate of $50 an hour. more than 97% of those who start day trading get a poorly paying job, at beat. Yet ALL of those people believed they would be in the 3% who are successful. Overconfidence can be deadly in the market!
2. Invest directly in stocks looking for short term or long term price increases. Rather than doing your own research, use the advice of a broker aligned with a company that does independent market research or an independent market information provider, such as a newsletter. Monitoring your current stocks and analyzing potential purchases should take 5 to 10 hours a week.
3. Do a lot of research and then buy shares based on long term company prospects, ignoring the short-term noise. Successful investors typically spend 10 to 15 hours per week staying current on the companies in which they have an interest. This is the strategy used by Warren Buffett,
4. Buy an Index Fund or Exchange Traded Fund to track the performance of the index they wish to track. The main requirement is to stay abreast of the trends in the economy. Invest an hour a day on a website with economic news,
5. Pay a professional money manager to perform the market research for you. In my practice, I look for fund managers who follow the same strategy as Warren Buffett. These managers have track records of outperforming their index over the longer term. Spend an hour at the start of each month to look at how the fund manager(s) performed last month, and meet with your advisor twice a year.

   Summary

   A lot of information in this post. Please feel free to check out the other posts on the options listed above. We're here to answer questions, but daon't expect a same day reply.